Credit default swap clearing

ABSTRACT

An electronic trading system is configured to trade credit default swap (CDS) futures contracts on an open exchange. The CDS futures contract allows the buyer and seller isolate and trade the credit risk of a third party. The third pay may be a corporation, sovereign government, or any entity that issues bonds or notes. The CDS futures contract seller effectively pays the premium over time in increments determined by market rates and through the natural operation of the open market. The CDS futures contract buyer makes a contingency payment if the CDS futures contract goes in-the-money (ITM). Both sides of the contract are guaranteed by the exchange as a counterparty.

TECHNICAL FIELD

The present invention relates to software, systems and methods forelectronic trading in a commodities exchange, derivatives exchange orsimilar business involving tradable items where orders from buyers arematched with orders from sellers.

BACKGROUND

A swap contract is a derivative in which two counterparties agree toexchange one stream of cash flows for another stream of cash flows. Acredit default swap (CDS) is a swap contract in which one leg is aseries of payments and the other leg is a one time lump payment if, forexample, an ISDA defined credit event occurs. FIG. 1 illustrates thatthe credit default swap buyer 20 makes a series of payments to thecredit default swap seller 10. In the event of a credit event, theseries of payments will cease and the credit default swap seller 10makes a lump payment to the credit default swap buyer 20. FIG. 2 furtherillustrates the cash flows between credit default swap seller 10 and thecredit default swap buyer 20.

An exemplary credit event is said to occur when a credit instrument goesinto default. Credit default swaps behave in a manner similar toinsurance. The buyer of the CDS makes a series of payments as the buyerof an insurance policy make a series of premium payments. The seller ofa CDS make a large payoff if a relatively unlikely event occurs in thesame way that an insurance company pays the insured in the event of aflood, fire, or car accident. CDS differ from insurance policies becauseneither the buyer nor seller in the CDS contract needs to be associatedwith the underlying instrument.

Even though credit default swaps were introduced only in the mid-1990's,the market has grown at an extraordinary pace. The notional value of theCDS market is estimated at $55 trillion, which exceeds the U.S. StockMarket, U.S. treasuries market, and mortgage market combined.

In spite of the size of the CDS market, the current infrastructurecannot support tracking the performance of a CDS contract. For thisreason, the CDS market is not transparent to the public. Consequently,many have criticized the CDS market, pointing to a lack of regulationand transparency.

Additionally, the CDS market operates on an over the counter (OTC)basis. An OTC is a bilateral agreement between two parties. An OTCinvolves counterparty risk because the other party of the bilateralagreement may default on the CDS contract.

A “clearinghouse” or “exchange” greatly reduces counterparty risk byacting as a counterparty to every trade. One example of an exchange isthe Chicago Mercantile Exchange Inc. (CME), which provides a marketplacewhere derivatives are traded and cleared. A CDS contract involves aseries of payments, which cannot be supported by existing industryinfrastructures.

As governments around the world are absorbing the riskiest corporatebalance sheets, sovereign credit is assuming many of the characteristicsof corporate debt purchased by governments. There was a time when themarket believed that interest rates, energy, and agricultural pricerisks didn't need to be hedged. The “great awakening” to sovereign riskparallels the realization in markets where hedging is now consideredcommon place.

What is needed is a system and method capable of trading a derivativethat will be behave in a similar fashion to a credit default swap whilestill adhering to futures pricing conventions and legacy infrastructure.

BRIEF DESCRIPTION OF DRAWINGS

FIG. 1 illustrates an OTC credit default swap.

FIG. 2 illustrates cash flows for an OTC credit default swap.

FIG. 3 illustrates an exchange and a CDS futures contract.

FIG. 4 is a graph of hypothetical CDS futures contracts.

FIG. 5 illustrates an electronic trading system.

FIG. 6 illustrates a detailed view of a contract generator of theelectronic trading system of FIG. 5.

FIG. 7 illustrates an exemplary process for trading CDS futurescontracts in an electronic trading system.

FIG. 8 illustrates one embodiment of the systems and devices forcarrying out the process of FIG. 7.

FIG. 9 illustrates an implementation of one of the devices in the systemof FIG. 8 for carrying out the process of FIGS. 7.

DETAILED DESCRIPTION

Credit default swap futures contracts are pay-as-you-go options. Thebuyer and seller isolate and trade the credit risk of a third party,known as a reference entity. The option buyer pays the premium overtime, while the seller has no responsibility unless the option goesin-the-money (ITM), at which point a contingency payment is owed to theoption buyer from the option seller. The option will either goin-the-money or expire worthless.

A difference between CDS and a traditional option is that the “trigger”for the option going in-the-money is not a market movement referencingthe price of a stock, bond, or commodity. A market movement is thetrigger that puts traditional options on stocks or futures in-the-money.CDS futures go in-the-money upon the occurrence of a credit event.

The reference entity may be a corporation or a sovereign that usuallyhas debt outstanding. Outstanding debt is a requirement for thereference entity, since CDS references the price of a defaulted note ifthere is a credit event. The outstanding debt is often a corporate bondor a government bond. In exchange for the contingency payment, theoption buyer may be required to make physical delivery of a bond or noteissued by the reference entity. Alternatively, the CDS futures contractmay be cash settled to a third party reference price.

The International Swaps and Derivatives Association, Inc. (ISDA) liststhe following credit events: (1) bankruptcy, (2) obligationacceleration, (3) obligation default, (4) failure to pay, (5)repudiation/moratorium, and (6) restructuring. This list could bealtered without changing the principle operation of the CDS. Further, itshould be noted that the possible credit events may different for asovereign than a corporate entity.

Bankruptcy generally refers to the events associated with insolvencyproceedings, but may be wider in scope to include even any action takenby the reference entity in furtherance of a bankruptcy. For example, aboard meeting that considered filing a liquidation petition. Anobligation acceleration is when the obligation comes due because of adefault by the reference entity. An obligation default occurs when thereference obligation is capable of being declared due. A repudiation ormoratorium is when the reference entity disaffirms, disclaims, orchallenges the validity of the obligation. Restructuring may include areduction in the principal amount or interest payable under theobligation, a postponement of payment, or a change in ranking ofpayment.

A CDS derivative that can be traded on a futures and commoditiesexchange would reduce the prevailing counterparty risk. However, thelegacy exchange infrastructures do not support the pay as you go natureof CDS. The conditional nature cannot be supported by the accrual of afixed coupon.

FIG. 3 illustrates an exchange capable of trading a CDS futurescontract. The buyer of protection is the seller of the CDS futurescontract, and the seller of protection is the buyer of the CDS futurescontract. The exchange 50 becomes the counterparty to both entities in acredit default swap. The protection buyer 52 is the CDS futures contractseller, and the protection seller 51 is the CDS futures contract buyer.The buyer of the CDS futures contract assumes a long at the price of thecontract. The seller of the CDS futures contract assumes a short at theprice of the contract. The price is quoted on an annual basis, in basispoints.

The exchange guarantees, when there is no credit event, that theprotection seller 51 will receive the premium every day until expirationof the futures contract. The exchange guarantees, when there is a creditevent, that the protection buyer 51 will receive the contingencypayment. The protection buyer 51 may be required to provide a bond ornote issued by the reference entity in exchange for the contingencypayment. The bond or note may be required to have a maturity within aparticular range.

The buyer of the futures contract receives the option premium over time,and is equivalent to the seller of protection in the OTC market. Thefutures contract is priced as a base value less the cumulative annualpremium. For example, a CDS with a notional value of $1 million may bepriced at 100 less the total premium due for the life of the instrument.If the annual premium were 100 basis points, then the price of a 5-yearfutures contract would be 95.00 points, which translates to $950,000 inthis example. Six months later, the price would be 95.50, if there wereno other changes in the market. By construction a 5-year contract wouldhave a dollar value of one (01) basis point (DV01) equal to $500. Ifthere is a credit event, the buyer of the contract is obligated to pay$1 million to the seller of the contract. In one implementation, theseller of the contract may be required to deliver $1 million face valueof a note of any maturity from the reference entity before the buyer ofthe contract is required to make the $1 million payment to the seller ofthe contract.

The amount of money that changes hands from the seller of the futurescontract to the buyer of the futures contract corresponds to the seriesof payments in the OTC CDS. For example, 100 basis points means onequarter of one percent or 0.25% of the notional is transferredquarterly. The market will naturally cause the price of the futurescontract to increase over time as the amount of time remaining for acredit event to occur decreases. Assuming, no change in the market'sperception of the risk attached to the reference entity, the price ofthe 5-year futures contract will slowly increase from the 95.00 initialprice to 100.00 at expiration. At that point, the position of the sellerof the futures contract (buyer of protection) will have gained 500 basispoints and the position of the buyer of the futures contract (seller ofprotection) will have lost 500 basis points.

FIG. 4 illustrates the behavior a credit default swap futures contract.The initial price at t₀ is 95 and the final price at expiration at theend of five years is 100.

The example shown by line 61 assumes no change in risk. That is, themarket does not perceive any change in the riskiness of the referenceentity from the beginning of the CDS contract at t₀ until the expirationof the CDS contract. The price of the futures contract increaseslinearly with the passage of time through daily mark to market accruals.The mark to market accruals will be a gain to the buyer of the futurescontract (long position in the CDS futures contract) and a loss to theseller of the futures contract (short position in the CDS futurescontract). Mark to market is the system by which the exchange pays orcollects from each trader based on the activities of the previous day(or other time period). The cumulative premium will effectively beprorated (and accrued) over 360 or 252 days (or some other number daysper year) over the lifetime of the instrument.

The price of the CDS futures contract is completely driven by themarket. The example shown by line 61 above assumes that the riskattached to the reference entity has not changed. However, if the marketperceives a change in the reference entity's risk, the price willchange.

If the market perceives that the reference entity becomes more risky,there is greater chance of a credit event and greater chance the sellerof protection will have to pay the notional amount. Accordingly, theprice of the futures contract will decrease. An example where the marketperceives more risk associated with the reference entity for a timeperiod is shown by line 63. However, the price of the CDS futurescontract at expiration must return to the final price of 100, unlessthere is a credit event.

Likewise, if the market perceives that the reference entity becomes lessrisky, there is less of a chance of a credit event and less chance thatthe seller of protection will have to pay the notional amount.Accordingly, the price of the futures contract will increase because thecumulative annual premium has decreased. An example where the marketperceives less risk associated with the reference entity for a timeperiod is shown by line 65. However, the price of the CDS futurescontract at expiration must return to the final price of 100.

FIG. 5 illustrates an electronic trading system including a plurality ofterminals 101, communication links 102, bus 109, a contract generator103, and a match engine 105. The contract generator 103 and match engine105 are coupled with each other as well as terminals 101. As usedherein, the phrase “coupled with” is defined to mean directly connectedto or indirectly connected through one or more intermediate components.Such intermediate components may include both hardware and softwarebased components.

The communication link 102 connects the terminals 101, contractgenerator 103, and match engine 105 over any sized geographical area. Inone embodiment, the communication link 102 includes a network such as alocal area network (“LAN”), a wide area network (“WAN”), a metropolitanarea network, a virtual area network, a wireless local network, a localbus, a direct or indirect satellite network, or combinations thereof.Further, the communications link 102 may include a publicly accessiblenetwork such as the Internet, a privately accessible network such as anIntranet, or a combination of privately and publicly accessiblenetworks. In one embodiment, the communication link 102 includes a dataconversion device, such as a modem, that converts data from one forminto another, e.g. converts data from one form usable with electronicequipment to another form useable over wireless or landlinecommunication technologies. Such conversion devices include conventionalmodems that can be used with the public switched telephone network,cellular modems and other network interface devices. Preferably, thecommunication link 102 provides a high-bandwidth data communication linkthat achieves high transmission speeds and low latency. Further, thecommunications link 102 may utilize secure protocols, such assecure-Hypertext Transfer Protocol (“HTTP”), pretty good privacy(“PGP”), etc., to ensure that communications among the devices coupledwith the link 102 are authorized, authentic and/or otherwiseuncompromised.

Preferably, terminal 101 includes a memory, an interface, a processor,and operating firmware/software that perform functions, such asreceiving input from a user, generating and transmitting instructions tocontract generator 103 to generate a CDS futures contract and receivinga response to those instructions. Terminal 101 may be a conventionalcomputer, a hybrid personal computer, a personal digital assistant(PDA), a laptop computer, a mobile telephone or any other device thatcan receive and send information through a communication link. Terminal101 may also include a display device, a keyboard, a mouse, a touchpanel, a graphical user interface (GUI), a printer, a scanner, and/orother input/output devices associated with a computer for interactingwith a user of the terminal 101. In one embodiment, terminal 101 is apersonal computer having a Pentium class processor, a suitable memory,hard disk and user interface and a network interface compatible with thecommunications link 102.

As shown in FIG. 5, terminal 101 is connected through the communicationlink 102 to the match engine 105. The communications link 102 alsoconnects the match engine 105 to the contract generator 103. In thedisclosed embodiments, the match engine 105 includes a matching system,i.e. a system capable of receiving bids and offers and otherwisemanaging the execution of trades in a marketplace, such as thoseprovided by Chicago Mercantile Exchange Inc., (CME Group) located inChicago, Ill. However, the embodiments disclosed herein are applicableto any trading or futures market in the United States or elsewhere inthe world, for example, the Chicago Board of Trade (CBOT), the Bolsa deMercadorias e Futoros in Brazil (BMF), the London InternationalFinancial Futures Exchange, the New York Mercantile Exchange (NYMEX),the Kansas City Board of Trade (KCBT), MATIF (in Paris, France), theLondon Metal Exchange (LME), the Tokyo International Financial FuturesExchange, the Tokyo Commodity Exchange for Industry (TOCOM), the MeffRenta Variable (in Spain), the Dubai Mercantile Exchange (DME), and theIntercontinental Exchange (ICE).

The match engine 105 matches orders, including resting orders and neworders, electronically according to one or more trade matchingalgorithms, such as a first-in-first-served algorithm, an allocationalgorithm, or a market maker priority algorithm. An “order” can be a bidto purchase or an offer to sell. In one embodiment, the match engine 105is implemented as a software program which executes on a computer systemcapable of executing the match engine 105 and interfacing with thecommunications link 102. Alternatively, the match engine 105 may beimplemented as a combination of hardware and software.

Although the match engine 105 and the contract generator 103 areillustrated as separate devices that are capable of being run on one ormore computers, in alternative embodiments these systems and methods canalso be integrated within a single device. The match engine 105 isfurther capable of operating in an automatic, semi-automatic or manualfashion.

FIG. 6 illustrates a detailed view of contract generator 103 of theelectronic trading system of FIG. 3. Contract generator 103 includes aprocessor 107, a database 115, a market interface 111, and acommunication interface 113.

Database 115 is a conventional storage system, such as a hard disk ormemory. Database 115 stores data regarding the contracts available inthe associated exchange/match engine. Database 115 may also includemarket data information, expert opinion and financial quotes.

Processor 107 may be any type of general purpose processor configured todefine a credit default swap futures contract according to the firstrequest and the second request using an initial price defined by afraction of a notional value of the bond less the premium payment.

Market interface 111 includes the hardware and/or software componentsnecessary to communicate with terminals 101 and communication link 102and bus 109 to receive a first request, from a first market participantvia one terminal 101, to provide a contingency payment triggered by theoccurrence of a credit event of a reference entity and a second request,from a second market participant at another terminal 101, to provide apremium payment to the first market participant in exchange for thecontingency payment triggered by the occurrence of the credit event.

Communication interface 113 includes the hardware and/or softwarecomponents necessary for the contract generator 103 to communicate withmatch engine 105. The match engine 105 receives the definition of theCDS futures contract stored in database 115 through communicationinterface 113.

FIG. 7 illustrates an exemplary process for trading CDS futurescontracts in an electronic trading system. At block S501, a request isreceived from a first market participant to provide a contingencypayment triggered by the occurrence of a credit event of a referenceentity. At block S503, a request is received from a second marketparticipant to provide a premium payment in exchange for the contingencypayment triggered by the occurrence of the credit event. The requestsmay be received in any order or simultaneously.

At block S505, a credit default swap futures contract is defined usingan initial price defined by a fraction of a notional value of the bondless the premium payment. For example, the price may be: 100—CumulativeAnnual Premium. At block S507, the match engine 105 executes a tradebetween the first market participant and the second market participant.Optionally, the electronic trading system may communicate or display thetrade. The trade may be displayed on one or more terminals 101.

FIG. 8 illustrates one embodiment of a system 600 configured toimplement one or more of the disclosed trading methods, allocationalgorithms, etc. The system 600 may include multiple terminals 602 to608 directly and/or indirectly in communication with an order managementterminal 610. For example, the terminals 602 and 604 may communicatewith the order management terminal 610 via the Internet 612, a wide areanetwork (WAN) and/or other communication networks. The terminals 606 and608 may communicate with the order management terminal 610 via, forexample, a communication network 614 such as an Ethernet network, awireless fidelity (WiFi) and/or other communication networks. The ordermanagement terminal 610 may, in turn, be in communication with adatabase 616 or other memory or storage device or medium. The database616 may be configured to store, in an accessible manner, theinformation, algorithms, parameters, etc. necessary to implement andmonitor the trading methods, allocation algorithms disclosed herein. Thedatabase 616 may be a separate device or logical construct or may be aportion of the order management terminal 610.

FIG. 9 illustrates one example of a logical configuration that may beimplemented in the order management terminal 710. For example, the ordermanagement terminal 710 may include a communication module 718 and amemory 720 in communication with a processor 724 via a communication bus722. The memory may include RAM, ROM, flash memory, or any other type ofknown storage medium. Moreover, the memory 720 may include the database716 stored thereon. The communication module 718 may be a wirelesscommunication module or may be a wired communication module.

The processor 724 may be a general purpose processor configured toexecute the disclosed trading methods, allocation algorithms, and othermethods disclosed herein. Alternatively, the processor 724 may representone or more application specific processor or modules, 724 a, 724 b, and724 c. For example, the module 724 a may be a FIFO allocation module orprocessor; the module 724 b may be a pro-rata allocation module orprocessor; and the module 724 c may be a tracking module or processorfor processing and updating the order state associated with each methodand/or algorithm.

The steps, elements and processes discussed herein may be encoded asprogram logic, computer readable code and/or instructions. These encodedelements, in turn, may be stored or embedded on a computer readablemedium such as, for example, a hard disk drive, a solid state drive orother storage medium. The computer readable medium may be incommunication with a processor which, in response to an appropriateinput or command, may execute the program logic stored on the computerreadable medium. The execution of this program logic may result in theexecution of the step, elements and processes embodied and discussedherein.

It should be understood that various changes and modifications to thepresently preferred embodiments described herein will be apparent tothose skilled in the art. Such changes and modifications can be madewithout departing from the teachings of the present invention andwithout diminishing its intended advantages. It is therefore intendedthat such changes and modifications be covered by the appended claims.

What is claimed is:
 1. An electronic trading system comprising: a hardware market interface configured to receive a first request from a first market participant terminal to provide a contingency payment triggered by an occurrence of a credit event of a reference entity and a second request from a second market participant terminal to provide a premium payment to a first market participant in exchange for the contingency payment triggered by the occurrence of the credit event; a contract generator, which is external to a match engine and which communicates with market participant terminals over a bus, that comprises: a computer processor configured to generate a credit default swap futures contract according to the first request and the second request using an initial price defined by a fraction of a notional value of a reference obligation less the premium payment, wherein the premium payment corresponds to a prevailing market rate of a plurality of payments over a duration of a credit default swap futures contract; a storage system that stores data regarding contracts; a clocking device configured to determine a passage of time; a software market interface communicatively coupling the computer processor of the contract generator to the hardware market interface; and a communication interface communicatively coupling the computer processor of the contract generator to a hardware communication link coupled to the match engine; the match engine communicatively coupled to the contract generator through the communication interface, wherein the match engine is configured to automatically execute a trade between the first market participant and a second market participant, wherein the first market participant assumes a long position in the credit default swap futures contract in the amount of the initial price and the second market participant assumes a short position in the credit default swap futures contract in the amount of the initial price; the hardware communication link that couples the contract generator to the match engine through the communication interface; and an exchange that guarantees the premium payment and the contingency payment and pays and collects mark to market accruals based on activities of a previous day, wherein the second market participant is required to exchange a bond issued by the reference entity for the contingency payment, wherein the computer processor of the contract generator is configured to linearly increase the initial price with the passage of time, as determined by the clocking device, through the mark to market accruals, and always return to a predefined final price at expiration of the credit default swap contract unless the credit event occurs before the expiration.
 2. The electronic trading system of claim 1, wherein the reference obligation is a corporate note or a corporate bond.
 3. The electronic trading system of claim 1, wherein the reference obligation is a government issued bond or a municipal bond.
 4. The electronic trading system of claim 1, wherein the match engine is configured to receive data indicative of whether the credit event has occurred.
 5. The electronic trading system of claim 1, wherein the credit event is a failure to pay, a bankruptcy, a debt restructuring, an obligation acceleration, or a repudiation.
 6. The electronic trading system of claim 1, wherein a clearinghouse assumes the counterparty risk of the credit default swap futures contract.
 7. The electronic trading system of claim 1, wherein the credit default swap futures contract is cash settled according to a third party reference price.
 8. An apparatus comprising: a hardware market interface configured to receive a first request from a first market participant terminal, to provide a contingency payment triggered by an occurrence of a credit event of a reference entity, to receive a second request from a second market participant terminal, and to provide a premium payment to a first market participant in exchange for the contingency payment triggered by the occurrence of the credit event; a contract generator, which is external to a match engine and which communicates with market participant terminals over a bus, that comprises: a computer processor configured to generate a credit default swap futures contract according to the first request and the second request using an initial price defined by a fraction of a notional value of a reference obligation less the premium payment, wherein the premium payment corresponds to a prevailing market rate of a plurality of payments over a duration of a credit default swap futures contract; a computer memory that stores data regarding contracts; a clocking device configured to determine a passage of time; a software market interface communicatively coupling the computer processor of the contract generator to the hardware market interface; and a communication interface communicatively coupling the computer processor of the contract generator to a hardware communication link coupled to the match engine; the match engine communicatively coupled to the contract generator through the communication interface, wherein the match engine is configured to automatically execute a trade between the first market participant and a second market participant, wherein the first market participant assumes a long position in the credit default swap futures contract in the amount of the initial price and the second market participant assumes a short position in the credit default swap futures contract in the amount of the initial price; the hardware communication link that couples the contract generator to the match engine through the communication interface; and an exchange that guarantees the premium payment and the contingency payment and pays and collects mark to market accruals based on activities of a previous day, wherein the second market participant is required to exchange a bond issued by the reference entity for the contingency payment, wherein the computer processor of the contract generator is configured to linearly increase the initial price with the passage of time, as determined by the clocking device, through the mark to market accruals, and always return to a predefined final price at expiration of the credit default swap contract unless the credit event occurs before the expiration.
 9. The apparatus of claim 8, wherein the reference obligation is a corporate note or a corporate bond.
 10. The apparatus of claim 8, wherein the reference obligation is a government issued bond or a municipal bond.
 11. The apparatus of claim 8, wherein the match engine is configured to receive data indicative of whether the credit event has occurred.
 12. The apparatus of claim 8, wherein the credit event is a failure to pay, a bankruptcy, a debt restructuring, an obligation acceleration, or a repudiation.
 13. The apparatus of claim 8, wherein a clearinghouse assumes the counterparty risk of the credit default swap futures contract.
 14. The apparatus of claim 8, wherein the credit default swap futures contract is cash settled according to a third party reference price. 